Options

Sorry (Not Really) – How We Profit from Dumb Option Buyers

By Lee Lowell  |  July 11, 2018

Ever think about your probability of winning or losing on a trade before you enter it?

I believe most people rely on gut instinct. If they decide to move forward with a trade, it’s because they “feel pretty good about it.”

But does your gut translate into actual odds?

For most investors, they typically know the odds of a stock trade are 50-50. There are only two outcomes, after all: up or down.

So right off the bat, you don’t have more than a 50% chance of winning. And that’s even after you’ve done your due diligence of research, chart reading, eating a good breakfast, watching CNBC, etc.

But why settle for 50-50 odds when I can show you how to improve your chances of a profitable trade to 95%?

A 1997-99 study conducted by the Chicago Mercantile Exchange revealed that buyers of S&P 500 and Nasdaq 100 put options failed more than 95% of the time.

As shown in the graphic, put-option buyers on the S&P 500 and Nasdaq 100 saw their trades expire worthless 93.9% & 95.2% of the time, respectively.

What does that mean?

It means that option buyers lost 100% of their invested funds up to 95.2% of the time. You don’t have to rely on your gut to know that’s horrible!

So why do they keep doing it, even today?

I’m not a mind reader, but I believe these option buyers are simply inexperienced. They just have no clue how likely it is for them to lose.

Said in another way… They don’t know their probabilities.

As sad as that seems, and as bad as I feel for them, it’s these not-so-smart option buyers that have lined my pockets and kept me in business for the last 27 years.

Sorry! But not really.

I mean, if you’re going to enter a cutthroat arena such as the options market, you better know what you’re doing.

I’m not a proponent of option buying (except for the deep-in-the-money strategy I wrote about here and here), especially out-of-the-money (OTM) options.

Buying OTM options has both a low probability of winning and a low barrier to entry – they’re cheap.
Low cost. Lower probability. It’s like playing the lottery.

So it’s not that hard to imagine someone thinking, “why not roll the dice?” Why not grab a scratch off when you pop into the 7-11 for a coffee?

I’ll tell you why not. It’s just throwing money away. Let’s take a closer look at why buying OTM put options is a losing proposition.

To win at option buying, not only do you have to get the stock’s direction correct, but you also have to predict the exact time frame (the expiration date) of when the stock will move.

That’s just too hard.

(If you can predict that, you probably should be buying lottery tickets as well.)

I harp on put-option buying more than call-option buying for one lone reason: The stock market historically moves higher over the long run.

When you buy a put option, you need the stock to go down for the trade to be profitable. If the market tends to move higher, then you’re already fighting a losing battle.

But inexperienced option investors don’t seem to know their history.

And that means they’re doomed to repeat it!

Let’s focus on another area of the same chart showing the results of call-option buyers.

These options also expired at high rates: 58.9% and 80.9% for the S&P 500 and the Nasdaq 100, respectively. However, they’re not nearly as high as the put options. I believe this to be the case because call option buying benefits from a rising market.

You would think that if the market rises over time, then call-option buying would have a much higher profitability rate.

That’s true, but only if you buy deep-in-the-money (DITM) call options.

In my experience, a majority of option buyers still concentrate on buying OTM options, which is why the loss rate is still very high.

Sorry! But, again, not really. This means more profits for my readers.

Let’s take one last look at our trusty probability calculator to bring it all home.

Below are the odds of Amazon.com (Nasdaq: AMZN) falling from its current price of $1,739 per share to $900 per share by the January 18, 2019, option expiration date.

As you can see from the two circled areas, Amazon has less than a 1% chance of falling below $900 (and staying there) by January 2019.

Said in another way, the stock has a 99.87% chance of staying above $900.

Why does this matter?

Because even though there’s practically no chance of Amazon falling that far, someone still believes it can… and that someone is willing to pay $1.50 per contract for that $900 put option.

You can easily collect $150 for each put option you sell to them. That adds up to an easy $1,500 if you sell 10 contracts.

Of course, this trade would obligate you to buy 100 shares of Amazon at $900 apiece for every option contract you sell, assuming the stock drops that far.

Think about it. Would buying Amazon at $900 be bad?

That could be the buy of the century.

But what you should take away from the trusty calculator is that a real person actually thinks Amazon will fall from $1,739 all the way down to $900 in the next six months. That’s why they’re paying $1.50 per contract for the put option.

You might be shaking your head right about now, and I wouldn’t blame you. I guess these folks don’t realize their odds of losing is greater than 99%.

Sorry! But (last time) not really.

My readers take advantage of this very situation, over and over, in my Instant Income Alert research service. We’ve made seven trades this year, and every single one of them is in the green.

Lee Lowell

A former Wall Street insider and floor trader, Lee Lowell has worked in the market for nearly 30 years now. He began his option trading career in 1991on the floor of the New York Mercantile Exchange (NYMEX) in New York City.MORE FROM AUTHOR